S.E.C. Putting Mutual Funds Under Scrutiny On Late Trading

Top officials of the Securities and Exchange Commission said yesterday that they had sent a letter to big mutual fund companies asking for additional information about trading in their shares.

The enforcement division wants all documents regarding the companies' policies on who can trade in their shares late in the day and who can jump in and out of their funds quickly.

It is also asking if there have been any changes made to these policies; the companies must respond by Sept. 15.

The action underscores the extent to which commission officials are moving to play regulatory catch-up after the announcement by Attorney General Eliot Spitzer of New York that mutual fund companies encouraged fraudulent trading activities.

Class-action lawyers filed their first suit against fund companies named in the complaint, while Mr. Spitzer continued to process the information provided by hedge funds and mutual funds.

On Wednesday, Mr. Spitzer's office reached a settlement with Edward J. Stern, saying that his hedge fund, Canary Capital Partners, traded in mutual fund shares after the markets closed and engaged in market timing through Bank of America, Janus and other fund companies.

According to state and federal securities laws, buying mutual fund shares after the market has closed, at that day's price, and trading them for profit the next day is illegal.

For now, regulators and prosecutors do not have evidence that late-day trading is widespread.

Market timing, though, in which investors trade in and out of funds in a short period of time, can be a lucrative strategy. It is one followed by a number of prominent hedge funds. While the practice is not illegal, such trading is publicly discouraged by executives at many large mutual fund companies.

High levels of market timing can harm a fund's performance in many ways, portfolio managers say.

Transaction costs increase, subtracting from the value of the fund, and rapid-fire trading can place a burden on a fund's management, forcing it to keep more cash on hand to satisfy steady redemption requests. Money that is held in cash -- and not invested -- can hinder performance, especially in a rising market.

In Mr. Spitzer's complaint against the hedge fund manager, Bank of America and Janus are said to have set up relationships that allowed Mr. Stern to use them for market-timing.

The complaint includes an excerpt from a prospectus for the Janus High Yield fund, one of the funds that Mr. Stern traded, that described the company's policy.

An error has occurred. Please try again later.

You are already subscribed to this email.

It is this last disclosure that could prove to be significant if Mr. Spitzer follows up with a criminal charge, an option that he says he is considering.

He is arguing that fund companies violated their fiduciary responsibility to shareholders by allowing, if not encouraging, certain clients to time the market, while publicly discouraging such activities.

This could put Mr. Spitzer on much better legal ground than in the case he brought against investment banks over tainted research.

There was always a question whether the Martin Act, a broad antifraud statute in New York that Mr. Spitzer used as a cudgel to force banks to settle, could be used to bring a criminal case against banks for issuing fraudulent research.

''For Mr. Spitzer, late-day trading and market timing are much stronger than cases of fraudulent research,'' said Robert G. Heim, a former S.E.C. lawyer. ''Research analysts believed the statements that they were making. Here, a prosecutor can show that companies actually violated their written policies.''

Class-action lawyers have moved quickly to follow Mr. Spitzer's lead. Lawyers at Bernstein Liebhard & Lifshitz filed what they said was the first suit on behalf of shareholders claiming that Strong funds and Janus funds were in breach of their fiduciary duties by allowing Mr. Stern to time the market and make trades after the close.

Officials in the S.E.C.'s enforcement division said yesterday that if the allegations in Mr. Spitzer's complaint were proved to be true, they would impose maximum civil penalties on mutual funds that engaged in these activities.

They also said that William H. Donaldson, the commission's chairman, had asked the fund trade groups to review their practices with regard to the disclosed allegations.

S.E.C. officials admit that they are a late entrant in these particular issues.

By explanation, they point out that Mr. Stern's fund, Canary Capital, was never registered with the commission, unlike many hedge funds.

These officials said that the blatant nature of Mr. Stern's after-market trading would have shown up on their radar had he been registered.

There was some tension between Mr. Spitzer and the commission about the short notice given to the S.E.C. before the announcement of the complaint.

Mr. Spitzer and Stephen M. Cutler, the commission's director of enforcement, had a long conversation yesterday in an attempt to rebuild lines of communication.

Though Mr. Spitzer has suggested that Mr. Stern's infractions are just a small part of a much bigger problem, it is still unclear whether other hedge funds have had similar relationships with mutual funds.

According to MAR Hedge, a newsletter that tracks hedge fund performance, only 4 of the 1,800 funds in its data base describe themselves as market timing funds.

While a number of other funds have multiple strategies and engage in some market timing -- like Millenium Partners, a $4 billion hedge fund contacted by Mr. Spitzer's office last week -- they allocate a relatively small amount to this business, hedge fund investors say.

Correction: September 6, 2003, Saturday A capsule summary in The Metro Section yesterday referring to an article in Business Day about scrutiny of a bank's mutual fund business by the New York State attorney general misidentified the bank. It is the Bank of America, not the Bank of New York.